Saturday, 8 July 2017

The Mounting Evidence That Credit Rating Agencies Have Not Changed

Here in Financial
Regulation Matters we have looked at the credit rating agencies on a number
of occasions, with the underlying sentiment being that the industry represents
an overarching problem when it comes to the failure of financial regulation. In
this post today the theme will be revisited in light of recent action by
European regulators. It is beyond question that the leading credit rating
agencies – Standard & Poor’s, Moody’s, and to a lesser extent Fitch Ratings
– played a central role in the Financial Crisis. Having been the focus of an extensive
United States Senate investigation, subsequent pieces of similarly
extensive legislation in the U.S. and the
E.U.
confirmed that the conduct of the rating agencies was not acceptable and that,
by use of regulation, their behaviour would be corrected. However, on the 1st
of June 2017, the European Securities and Markets Authority (ESMA) issued
a relatively small fine of €1.24 million to Moody’s, for breaching European
credit rating regulations. Whilst the fine may look modest, it actually
represents just the latest in a long line of financial penalties that have been
given to the agencies not including
fines for their transgressions during the Financial Crisis era. With that in
mind, it is contested here that the continued transgressing of the agencies
represents who they are and,
ultimately, that regulation in its current form cannot correct that behaviour.

This author
has spoken of the near-$2 billion financial penalty that was given to ‘The
Big Two’ (S&P and Moody’s) before, so with that and the extended
coverage given to the fine, it will be better to focus on the actions of
the agencies after this period. If we
look at the multiple press releases from the regulatory agencies concerned, we
can see that the rating agencies did not stop transgressing whatsoever after
the crisis, it was just that the environment meant that their transgressive
nature had less of an impact. In 2011, S&P had rated a number of Commercial Mortgage-Backed Securities (CMBS) – as
opposed to the Residential Mortgage-backed Securities that stood at the heart
of the Financial Crisis – but, crucially, had publicly disclosed
that it was using a certain methodology when, in fact, it was using something
completely different (the issuers of the securities were aware, of course).
For this illegal breach, the agency was fined $77 million and banned from
rating similar securities for 12 months. If we look at the recent breach of
regulations by Moody’s, we can see they have been punished for exactly the same
thing. ESMA confirmed that the penalty was ‘regarding
their public announcement of certain ratings and their public disclosure of
methodologies used to determine those ratings’, which related to 19 ratings
issued by the rating agency between June 2011 and December 2013. It is
important to note that the recent $2 billion in penalties given to S&P and
Moody’s was not because of all of their transgressions during the crisis, but
mostly because of their involvement in scams using ‘Special
Investment Vehicles’ with which they colluded with issuers to defraud
investors – the rating agencies clearly
have ‘form’ for defrauding investors, despite their many claims to be doing the exact opposite.

Whilst a number of other agencies have been fined for
transgressing since the Financial Crisis, it is usually for other reasons than outright fraud. Though ESMA’s fine
of €1.38 million to Fitch Ratings for transmitting information prior to
publication is not really a good demonstration of this point, the $6
million fine given to the much smaller DBRS agency demonstrates the
technical aspects of being a smaller agency that may force an agency to fall
foul of the regulations. However, S&P and Moody’s have no such defence.
Yes, the headline-grabbing fines given by the SEC recently will live long in
the memory, but the actual situation is that the rating agencies have simply
maintained their approach. The issue with that should be clear; whilst the
current financial environment dictates that the effects of that approach will
be relatively minor, what happens when that environment changes? This author recently
discussed how the ever-expanding auto-finance bubble may alter the
environment for credit rating agencies, but in actual fact it could be anything
– and that is the worry. For that worry to subside, it is crucial that the
regulators and legislators create rules that focus on the actual behaviour of the agencies, and not how some stereotypical
agency may act. Rather than trust in the agencies to follow regulations, they
must instead be forcibly enforced, because the top agencies are consistently
proving that they cannot be trusted to operate within the confines of the law.
Yet, the current political landscape – particularly in the U.S. – suggests that
this level of state intervention is steadily becoming ever more of a dream. The
consequences of that could be severe.

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